I became intrigued by an oddity that I came to think of as the end-of-the-world trade. The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm -- around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt -- for the insurance to be paid out.Via Ken MacLeod, who comments: "You can insure against the revolution? Who knew?"
I asked one investment banker what might cause half of North America's top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even 'the big one', a catastrophic earthquake devastating California. All he could think of was 'a revolutionary Marxist government in Washington'. That's not a likely scenario, yet the cost of insuring against it had shot up ten-fold. Normally one can buy $10 million of end-of-the-world insurance for between two and three thousand dollars a year. By early last November, the prices quoted were between twenty and thirty thousand, and even then it was difficult to buy in quantity -- at least, said the banker, 'not from anyone you trusted'.
You'll Be Happy to Hear the Revolutionary State Has Seized Everything Except the Insurance Industry
Talk about markets in everything:
Comments to "You'll Be Happy to Hear the Revolutionary State Has Seized Everything Except the Insurance Industry":
Jesse Walker | May 14, 2008, 10:01am | #
I'll save the answer to the obvious question for the comments. From the article:All this activity explains the attractiveness of the end-of-the-world trade. The trade is the buying and selling of protection on the safest, super-senior tranches of the investment-grade indices. No one buys protection on these tranches because they are looking for a big pay-out if capitalism crumbles: if nothing else, they have no reason to expect that the institution that sold them protection would survive the carnage and be able to make the pay-out. Instead, they are looking to hedge their exposure to movements in the credit market, especially in correlation. Traders need to demonstrate they’ve done this before they’re allowed to book the profits on their deals, so from their viewpoint it’s worth buying protection, for example from ‘monolines’ (bond insurers), even if the latter would almost certainly be insolvent well before any pay-out on the protection was due.
robc | May 14, 2008, 10:10am | #
Jesse,That answers my obvious question, but leads to another. If no one expects a payout, why is there a market for this at all, and how can it be used as a hedge? If I was analyzing their positions, I would consider that as zero value, and therefore not a hedge.
D.A. Ridgely | May 14, 2008, 10:16am | #
Didn't you already cover this in your recent book about McCain?Pro Libertate | May 14, 2008, 10:18am | #
Put the insurance company on the Moon.To clarify, the only folly in this is buying such insurance. Selling it is a lovely idea. I'm going to sell insurance against the occurrence of a robot takeover.
"You can insure against the revolution? Who knew?" Yes, you can. With weapons.
bigbigslacker | May 14, 2008, 10:18am | #
"That's not a likely scenario"Well, I'm not voting for Obama either, but I wouldn't consider his victory unlikely.
News flash: Jesse is also Richard Bachman and Stephen King is a liar. Jesse, The Running Man was great.
Jesse's "Theory of Moral Sentiments" could have gone a little deeper into off-shore radio stations.
So basically buyers are just looking to park their money somewhere. But since there's zero expectation that the policy could actually pay out, it's just another speculative market, as evidenced by the recent irrational run up in price. This bubble must burst and the 'end of the world market' will inevitably collapse. Therefore buying this insurance is a high-risk speculative play of the exact opposite nature from the exposure hedge they are ostensibly being purchased for.
MP | May 14, 2008, 10:51am | #
it's just another speculative market, as evidenced by the recent irrational run up in price.It would only be a speculative market if the buyers had the right to re-sell their policy. This seems to be simply a market that capitalizes on irrationality and stupidity.
Back in 1998, I though of selling apocalypse insurance for Y2K. I was going to cover people for the end of the world caused by "Acts of God". Figuring that it was a) unlikely and b) if the end of the world came, I'd be long gone. I just couldn't figure out how to get through the regulatory hoops to legally do this.
And by Y2K, I mean the year 2000 and not the expected breakdown of global computing.
Warren | May 14, 2008, 11:00am | #
It would only be a speculative market if the buyers had the right to re-sell their policy.That's true. What makes you think they can't re-sell? Because that would make even a ten-fold price run-up even more inexplicable.
gorgonzola's foil | May 14, 2008, 11:02am | #
Someone has to buy the long tail to get it off the books, I get it. Lloyds syndicates used to do this internally, and look what the asbestos liability got them. Now, there's a market.I'd be afraid of the counterparty risk, though. What keeps the insurance underwriter from being 1/3 of the failed companies? Is it covered by a Superfriends combination of Munich Re, Swiss Re and Berkshire Hathaway?
MR | May 14, 2008, 11:04am | #
Ummm, why cannot this (hypothetical?) insurer be based outside USA? Even this end-of-the-world marxist president in Washington is not the end of the world...ktc2 | May 14, 2008, 11:05am | #
I'm lost. Why buy insurance that has zero chance of ever paying out? How is that in any sense a hedge against anything? You're just giving your money to someone in exchange for . . . nothing, ever.MP | May 14, 2008, 11:07am | #
What makes you think they can't re-sell?Insurance is not usually tradeable. However, after scanning TFA (it's very long), it appears that this is a form of derivative trading and not true insurance, thus it is a tradeable entity.
So it looks like you're right.
Mo | May 14, 2008, 11:10am | #
Ummm, why cannot this (hypothetical?) insurer be based outside USA? Even this end-of-the-world marxist president in Washington is not the end of the world...The US economy is 20% of global GDP, so while it's not the end of the world, the rest of the world is f-ed. Not to mention that the largest multinationals are based in the US. The revolutionary Marxist governments aren't going to be pleased with Goldman Sachs, IBM, McDonalds, Coke, etc. Their foreign offices will still run, but they're not exactly hydras, where cutting off their head will have no negative effect.
Lost_In_Translation | May 14, 2008, 11:19am | #
Judging from Jesse's answer to the obvious question, this appears to be yet another form of accounting magic, insisted on by auditors in industries that deal with credit and trade confidences. It doesn't make sense to anyone but someone that deals in moving money to make money. If you're selling something other than confidence in the world economy, this makes absolutely no sense, but if the product you're selling is bets on trade deficits, government bonds and other intangibles, then you probably have to play this charade with your accounting group to get investors to believe in your product. In the end, its all a shell game.NeonCat | May 14, 2008, 11:20am | #
@ Pro LibertateThose wouldn't be robots that run on old people's medicine, would it? Strong robots with metal claws?
Brian24 | May 14, 2008, 11:22am | #
MP is correct. The use of the word "insurance" is a metaphor for complex derivatives markets designed to serve as a hedge against the default of very senior bond tranches.They are available in different markets as well. For example, you could purchase "insurance" against AAA securities backed by residential mortgages on the RMBX index. I believe that in order for this contract to pay off, something like 20-30% of all US homeowners would have to default. Very unlikely, but according to most banks' internal rules, all trades have to be hedged appropriately, so there is a market.
Lost_In_Translation | May 14, 2008, 11:24am | #
Brian24,I see. If that is correct, I retract my previous statement. However, I still think this is a market created by accounting rules.
Mo | May 14, 2008, 11:41am | #
That's true. What makes you think they can't re-sell? Because that would make even a ten-fold price run-up even more inexplicable.The magnitude of the run-up is inexplicable, but there is a reason for a significant increase. The value of these derivatives goes up if their credit ratings go down. If the market perceives a significant chance of major changes to credit ratings, then there is value.
Example, let's say I get a derivative to hedge against default of GE corporate bonds. GE is AAA rated and the chance of default is close to zero. However, if GE is downgraded to AA because of exposure in their finance division, the value of the default hedge goes up, even if there's still a vanishingly small chance they'll default.
That, in combination with a lack of liquidity, counterparty risk and credit tightness is the reason the values have gone up so much. A 10-fold increase seems to be far to high, but I don't have access to these derivatives to short them, so I can't profit off of my belief.
Warren | May 14, 2008, 11:41am | #
MPRTFA I second your observation on its length. While it does confirm that these are derivatives that can be bought and sold. The article claims that the price spike is the result of a lack of liquidity. If I understand correctly, this is due to relatively few institutions being allowed to construct these types of CDOs.
So it looks like bean counter bullshit. Buying this "protection" satisfies the accounting rules to book your profit. But this is basically selling assets of no value for cash, made possible by forbidding just about everybody from cashing in on the free money.
But they are traded on an open market, so it will correct itself eventually. The correction is just being delayed by regulation.
Pro Libertate | May 14, 2008, 11:49am | #
NeonCat,It's a broad policy, covering all robot takeovers.
Warren | May 14, 2008, 11:52am | #
MoI understand what you are saying. However, your example is not apt. Hedging against GE is a legitimate investment. Even though the chances of its collapse are tiny, you have a reasonable expectation the derivative would pay out in the unlikely event that it does. Even though the derivatives are bought and sold valued on GEs current perceived health without regard to impending default, there is still some real asset backing it up.
The 'end of the world' derivatives are different, they are complete fiat with absolutely nothing backing them up. Their only real value is as a sort of fee to the accounting world. Sooner or later they must necessarily go to zero. There's simply no there there.
Kolohe | May 14, 2008, 11:55am | #
Peter Thiel, founder of paypal, has some related thoughts in the full essay linked to by this marginal revolution post.He sorta of said the opposite: Asset prices will always represent a slightly higher "expected value" than would be calculated with perfect knowledge of the 'true' probabilities, because there are no counterparties to the non-zero probability utter catastrophic failure.
This is embodied when he says, to paraphrase, 'Bet on China to succeed, because you won't be able to collect if it fails.'
"You can insure against the revolution? Who knew?" Yes, you can. With weapons.
No, that's just insuring you can participate meaningfully in the debate.
No, that's just insuring you can participate meaningfully in the debate.
Gahan | May 14, 2008, 12:35pm | #
I'll stick with my basement full of canned peaches and beef jerky, thank you very much.Gahan | May 14, 2008, 12:38pm | #
Pro Libertate,Does your robot policy cover diesel trucks and household appliances that inexplicably come alive and start attacking people?
P Brooks | May 14, 2008, 12:41pm | #
the price spike is the result of a lack of liquidityI would like to believe the lack of liquidity is due to a shortage of
Sign me up too, and I'll take the "involuntary servant of the machine overlords" rider, please...
Gahan | May 14, 2008, 1:28pm | #
How dare you try to gouge me when countries like Cuba provide free robot protection to their citizens. Socialized robot insurance for all!Pro Libertate | May 14, 2008, 1:33pm | #
Taktix®,There is an umbrella policy as well--don't miss this opportunity to protect your family.
Gahan,
That's a myth. Cuba is totally unprepared for the advent of the machines. Japan, on the other hand, is too prepared, having fallen victim to robot geishas some years ago.
robc | May 14, 2008, 1:48pm | #
Pro Lib,The robot takeover happened in 2000.
New Zealanders wouldnt lie to me, would they?
Pro Libertate | May 14, 2008, 1:57pm | #
New Zealand? What does New Zealand know about robots? Sheep, opposition to nukes, and lovely settings for fantasy movies, yes, but not robots.The 'end of the world' derivatives are different, they are complete fiat with absolutely nothing backing them up. Their only real value is as a sort of fee to the accounting world. Sooner or later they must necessarily go to zero. There's simply no there there.
There's something backing it up, it's unlikely, but there's a return (sorta). It's like the people that buy the S&P 500 = 900 calls. There's virtually zero chance it will happen, so it seems like free money. Then one does hit and the contract sellers are f-ed.
"Bet on China to succeed, because you won't be able to collect if it fails."
That's a dumb, ahistorical statement. Japan was way bigger and badder in the 80s, its economy failed in the 90s and those that bet against Japan became rich men.
There's something backing it up, it's unlikely, but there's a return (sorta). It's like the people that buy the S&P 500 = 900 calls. There's virtually zero chance it will happen, so it seems like free money. Then one does hit and the contract sellers are f-ed.
"Bet on China to succeed, because you won't be able to collect if it fails."
That's a dumb, ahistorical statement. Japan was way bigger and badder in the 80s, its economy failed in the 90s and those that bet against Japan became rich men.
joshua corning | May 14, 2008, 3:22pm | #
Via Ken MacLeod, who comments: "You can insure against the revolution? Who knew?"10$ says no one sells insurance against a free market revolution.
10$ says no one sells insurance against a free market revolution.
Sure they do, it's just called an out of the money put for the Wilshire 5000.
Sure they do, it's just called an out of the money put for the Wilshire 5000.
R C Dean | May 14, 2008, 4:12pm | #
$10 says no one sells insurance against a free market revolution.That's because you only insure against bad things happening, not good things.
That's because you only insure against bad things happening, not good things.
Which explains why the market for blowjob insurance never got off the ground.
Which explains why the market for blowjob insurance never got off the ground.
T, YOU BESOTTEN FOOL, NO ONE HAS EVER ATTEMPTED TO ISSUE BLOW JOB INSURANCE. HOWEVER, THE URKOBOLD HAS MADE A TIDY PROFIT ON INSURING AGAINST THE EVENT OF A NON-BLOW JOB. PART OF THE URKOBOLD'S DATE SATISFACTION COVERAGE FOR MEN.